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What is a derivative?

The term Derivative is used everywhere. Boring calculus books make you derive derivatives. English teachers tell you that a body of work is “merely Derivative”. If the word couldn’t get any more boring, you hear the term in the financial context. Most financial articles can’t go a paragraph or two without name dropping a type of Derivative. It might be helpful then to know what a derivative is. Below is a definition of derivatives taken from the “Dictionary of Financial Engineering ” by John F. Marshall . Don’t worry if you don’t understand the definition on the first reading. I will break it down as best as I can.

“A generic term to describe a wide variety of financial instruments ranging from standardized, exchange-listed products to custom-made, over-the-counter instruments whose values depend on, or are derived from, the price or value of one or more underlying assets, including indexes, exchange rates, interest rates, or commodity prices. “

Wow. That had a lot of words. They seemed to logically follow one another in a sentence, but at this point some of you are taking my word for it that that meant something. Let’s take the first part. What is an “exchange-listed product”? This just means that there’s some trading floor (or some place online), similar to the New York Stock Exchange, where people will buy and sell financial products that do the same thing. In other words, the products are fungible. Just like one dollar bill does exactly the same thing as another dollar bill, one of these financial products does (or is supposed to do) the same thing.

From this, it’s easy to figure out what a “custom-made, over-the-counter instrument” is. It’s simply the opposite! Rather then being “listed” on some exchange somewhere and buying it on an exchange, people buy the products on their own. More specifically, there’s a person named a “dealer” (also called a “market maker”) who both buys and sells the same product and makes money on the price difference between the price he/she pays for products and the price he/she is paid when selling them (or at least that’s the ideal, more on this in later posts). You can think of a market maker as similar to your local corner or grocery store. They buy products from suppliers, sell those same products to you and make money on the difference.

Now how about that second part? “Instruments whose values depend on, or are derived from, the price or value of one or more underlying assets, including indexes, exchange rates, interest rates, or commodity prices”. This is much simpler then it sounds. All that’s being said is a derivative doesn’t have some inherent value tied to it, it’s worth is based on the value of something else. I’ll give a simple example. Let’s say that I go to my local farmer and tell him “hey, if you sign right here, I’ll pay you 2 dollars every week for a year for the right to buy a bushel of apples for 10 dollars at any point during that year”.

That’s called an “option” because I’m paying for the option of buying apples at a certain price. When the price of apples goes down (up), the value of this option goes down (up) because the privilege to buy a bushel of apples at 10 bucks is less (more) appealing the lower (higher) the price. If I can go out and buy a a bushel for 5 dollars that option won’t be worth very much to me but if the spot (immediate) price is 30 dollars the option becomes more valuable. This principal of basing the value of an asset on another asset can and has been extended to nearly every conceivable thing from those listed above to the weather and movie earnings. In the same way your bet on Jeremy Lin is based on Jeremy Lin’s performance, you can design a custom contract to be valued based on the performance of nearly any measurable thing on the planet just as long as you can find someone to take the other side of the bet.

The key problem is that last point : “finding someone to take the other side of the vet”. If you come up with this great product that guarantees profits for you, in what situations would it make sense for someone (or some organization) to be the “counterparty”? If there as a result, dealings in derivatives tend to circulate around a handful of major products (albeit often customized to fit the perceived needs of each party). There are situations however, where someone (or an organization) has been a counterparty to a transaction detrimental to it. why is that? In future posts we will start covering the functioning of more specific products and how they can and have impacted the financial system and, ultimately the 99%.